Question

Question 2:

Using the CAPM (capital asset pricing model) and SML (security market line), what is the expected rate of return for an investment with a Beta of 1.8, a risk free rate of return of 4%, and a market rate of return of 10%.

Answer 1

Solution:

As per Capital Asset Pricing Model, Expected return on an Investment is calculated using the following formula :

R_S = R_F + [ β * ( R_M - R_F ) ]

Where

R_S = Expected rate of return on an Investment ; R_F = Risk free rate of return   ; β = Beta   ;

R_M = Market rate of Return

As per the information given in the question we have

R_M = 10 % = 0.10 ; β = 1.8   ; R_F = 4 % = 0.04   ;

R_S = To find ;  

Applying the above information in the formula we have

= 0.04 + [ 1.8 * ( 0.10 – 0.04 ) ]

= 0.04 + [ 1.8 * 0.06 ]

= 0.04 + 0.108

= 0.148

= 14.8 %

Thus the expected rate of return for an investment = 14.8 %